Page 1 of 4 CREDIT BUBBLE BULLETIN The Wall Street bust
Commentary and weekly watch by Doug Noland
I still owe readers a thorough analysis of the Q2 2008 flow of funds. For now,
I'll just point out some data relevant to the current state of acute fragility.
Looking back, Total Non-Financial Debt (NFD) expanded US$578 billion during
1994. By 1998, NFD growth for the year had surpassed $1.0 trillion.
Non-Financial Credit increased $1.153 trillion in 2001, $1.415 trillion in
2002, and $1.676 trillion in 2003, before reaching the $2.0 trillion milestone
in 2004. Incredible as it was, debt expansion then surged over the next fateful
three years. Growth rose to $2.319 trillion in 2005, $2.428 trillion in 2006
and
then to last year's record $2.561 trillion.
Importantly, this historic credit inflation inflated asset prices, incomes,
corporate cashflows/earnings, government revenues, and various types of
spending throughout the US and global economy. It was a self-sustaining bubble
bolstered by ongoing credit excesses, asset inflation and resulting purchasing
power gains. But NFD growth slowed sharply to an annualized $1.726 trillion
during this year's first quarter and then sank to $1.127 trillion annualized
during the second quarter. Credit growth is now in the process of collapsing.
At this point, there is clearly insufficient credit expansion to support
inflated asset markets; incomes and household spending; corporate cash flows
and investment; and government receipts and expenditures. Lending markets are
frozen, securitization markets broken, corporate and municipal debt markets in
disarray, derivatives markets in shambles, and the leveraged speculating
community is engaged in panic de-leveraging.
As a consequence, the over-indebted household, corporate and state and local
sectors now face a devastating liquidity crisis.
We are today witnessing the acute stage of bursting credit bubble dynamics.
It's an absolute debacle, and there's little our well-intentioned policymakers
can do about it other than try to slow the collapse. To be sure, there were
momentous effects to both the economic and financial structures during the
bubble period between 1994's $578 billion non-financial debt growth and 2007's
$2.561 trillion. It is also worth noting that financial sector debt expanded
$462 billion in 1994 compared with $1.753 trillion in 2007. Mortgage debt
almost doubled in the six years 2002 through 2007 to $14.0 trillion, while
financial sector borrowings rose 75% to $16.0 trillion.
This credit onslaught fostered huge distortions to the level and pattern of
spending throughout the entire economy. It is today impossible both to generate
sufficient credit and to main previous patterns of spending. Economic upheaval
and adjustment are today unavoidable.
Over the years I've chronicled this historic bubble in Wall Street finance. It
is worth recalling today that Wall Street assets began year 2000 at about $1.0
trillion and ended 2007 at $3.0 trillion. The ABS market surpassed $1.0
trillion in 1998 and ended 2007 at $4.5 trillion. Assets of
government-sponsored enterpises, notably mortgage guarantors Feddie Mae and
Freddie Mac surpassed $1.0 trillion in 1997 and ended last year at almost $3.4
trillion. Agency MBS surpassed $2.0 trillion in 1998 and closed 2007 at almost
$4.5 trillion. "Fed Funds and Repos" reached $1.0 trillion in 2000 and ended
2007 at $2.1 trillion. This Bubble in Wall Street Finance was one of history's
most spectacular Credit expansions. It also comprised the greatest use of
speculative leverage ever.
Despite last summer's collapse in private-label MBS and related markets, the
faltering Wall Street Bubble nonetheless persevered up until the Lehman
Brothers collapse in mid-September this year. While it was problematic that
overall system credit growth had slowed markedly, there remained key sectors of
credit and risk intermediation that remained very much in expansionary mode. In
particular, GSE-related obligations, bank credit, and money market fund assets
had expanded rapidly in spite of the subprime collapse.
Importantly, the speculator community had maintained easy access to cheap
finance. As I have noted often, despite the unfolding bust in mortgage and risk
assets, market faith in "money" and the core of the system had held steadfast.
This all ended abruptly three weeks ago with the Lehman filing for bankruptcy.
Today, confidence has been shattered, and Wall Street finance is a complete and
unsalvageable bust. The spigot for trillions of finance - which for years
fueled the asset markets and US bubble economy - has been essentially shut off
and dismantled. In particular, Wall Street finance was a mechanism for
intermediating higher-yielding riskier loans. This finance provided rocket fuel
for both residential and commercial real estate markets - and the attendant
wealth effects.
Wall Street finance also grew into the key source of finance for auto
purchases, student loans, Credit cards, municipal finance and various business
enterprises. Many of these loans were of a risk profile unappealing to
traditional bank lending - and, hence, provided the type of higher yields quite
appealing to the speculator community.
And, importantly, as the stature of Wall Street finance grew, its impact upon
the real economy became embedded deep into the economic structure. Or, stated
differently, risky loans came to play a major role in determining spending and
investment patterns throughout the "bubble" economy. Wall Street finance became
a major direct and indirect generator of household incomes and corporate
profits.
Moreover, Wall Street finance came to dominate the flow of finance both in and
out of the securities markets. Wall Street could create its own liquidity and
funnel it into the US and global markets - and earn unimaginable returns in the
process.
It is today impossible to comprehend the full ramifications from the bust in
Wall Street finance. Yet we can be rather certain that for the foreseeable
future much less credit and liquidity will be directed to the asset markets.
And, at the same time, there will be significantly less credit availability for
riskier loans of all varieties - for the household, business, financial and the
government sectors.
Few appreciate that these dynamics are extremely problematic for the US bubble
economy - an economic system that had come to a large extent to be governed by
asset-based and high-risk lending. These dynamics are at the heart of today's
acute financial and economic fragility and the resulting imploding markets.
The leveraged speculating community played such an integral role in the overall
credit bubble and, more specifically, to the bubble in Wall Street Finance.
They were instrumental in both spurring financial sector credit
creation/leveraging, while directing this flood of finance to the asset
markets. And the more the leverage and the greater the flow to inflating
markets, the higher the returns generated by this expanding pool of speculative
finance. And the greater the returns, the more robust the "investment" flows
into the hedge fund community - spurring more leverage and more potent fuel for
additional self-reinforcing asset inflation.
Well, this historic speculative bubble is now in the process of blowing up. One
of the greatest manias ever - surely the world's greatest episode of Ponzi
finance - is absolutely coming apart. And the wreckage is accumulating in all
markets - everywhere.
Here in the US, our maladjusted economic system will only be sustained by
somewhere in the neighborhood of $2.0 trillion of new credit. It's simply not
going to happen. The $700 billion from Washington would seem like an enormous
amount of support. In reality, it's nowhere even close to the amount necessary
for systemic stabilization. To the $2.0 trillion or so of new credit required
this year (and next) add perhaps as much as several trillion more necessary to
accommodate speculative de-leveraging (liquidations forced by huge losses).
Importantly, the bust in Wall Street Finance has ensured that insufficient
liquidity will be forthcoming to maintain inflated asset prices and sustain the
bubble economy - creating catastrophe for the leveraged speculating community.
The "Freidmanites" thought they understood the (post-crash) policy mistakes
that led to the Great Depression. They believed the Roaring Twenties was the
golden age of capitalism. The great bust could have been avoided with a simple
($5 billion or so) banking system recapitalization. As we are witnessing today,
the issue is not some manageable amount of new "capital" to replenish banking
system losses. Instead, the predicament is the massive and unmanageable amount
of new credit necessary to, on the one hand, sustain a mal-adjusted bubble
economy and, on the other, the trillions more required to accommodate a
gigantic speculative de-leveraging. I have a very difficult time seeing a way
out of this terrible mess.
WEEKLY WATCH
For the week, the Dow was hit for 7.3% (down 22.2% y-t-d), and the S&P500
was clobbered for 9.4% (down 25.1%). Economically-sensitive stocks were, again,
pounded. The Morgan Stanley Cyclicals sank 14.2% (down 30.8%), and the
Transports dropped 13.0% (down 9.5%). The Utilities fell 6.0% (down 23.6%), and
the Morgan Stanley Consumer index lost 5.2% (down 13.6%). The broader market
was under heavy selling pressure. The small cap Russell 2000 (down 19.1%) and
the S&P400 Mid-Caps (12.1%) were both hit for 12.1%. The NASDAQ100 sank
12.0% (down 29.5%), the Morgan Stanley High Tech index dropped 13.1% (down
30.6%), and the Semiconductors were hit for 11.5% (down 30.2%). The Street.com
Internet Index fell 11.1% (down 23.5%), and the NASDAQ Telecommunications index
sank 12.3% (down 27.5%). The Biotechs dropped 8.7% (down 6.7%). The
Broker/Dealers declined 9.3% (down 43.2%), and the Banks dipped 0.6% (down
17.1%). With Bullion sinking about $42, the HUI Gold index was crushed for
18.3% (down 34.2%).
One-month Treasury bill rates dropped to 0.10% and three-month yields to 0.48%.
Two-year government yields ended the week down 50 bps to 1.59%. Five-year
T-note yields sank 42bps this week to 3.06%, and 10-year yields dropped 24bps
to 3.61%. Long-bond yields declined 28 bps to 4.10%. The 2yr/10yr spread
widened 26 to 201 bps. The implied yield on 3-month December '09 Eurodollars
sank 56 bps to 2.96%. Benchmark Fannie MBS yields declined 6 bps to 5.43%. The
spread between benchmark MBS and 10-year T-notes widened 18 to 182 bps. Agency
10-yr debt spreads widened 5 to 82.5 bps. The 2-year dollar swap spread
increased 8.75 to 151.75, while the 10-year dollar swap spread declined 1.5 to
66. Corporate bond spreads were wider. An index of investment grade bond
spreads widened 5 to 166 bps, and an index of junk bond spreads widened 42 to
688.
Debt markets were essentially frozen. Investment-grade debt issuance included
Union Pacific $750 million, Interstate Power $250 million, and Wisconsin
P&L $250 million.
I saw no junk, convert or international debt issuance this week.
German 10-year bund yields dropped 24 bps to 3.92%. The German DAX equities
index dropped 4.4% (down 28.1% y-t-d). Japanese 10-year "JGB" yields were
little changed at 1.445%. The Nikkei 225 fell 1.9% (down 28.5% y-t-d). Emerging
markets remained under pressure. Brazil's benchmark dollar bond yields surged
42bps to 6.84%. Brazil's Bovespa equities index sank 12.3% (down 30.3% y-t-d).
The Mexican Bolsa dropped 10.2% (down 22.2% y-t-d). Mexico's 10-year $ yields
rose 11 bps to 6.10%. Russia's RTS equities index sank 16.7% (down 53.2%
y-t-d). India's Sensex equities index sank 7.5%, with y-t-d losses rising to
38.3%. China's Shanghai Exchange was closed for a holiday week (down 56.4%
y-t-d).
Freddie Mac 30-year fixed mortgage rates added one basis point to 6.10% (down
27bps y-o-y). Fifteen-year fixed rates also increased one basis point to 5.78%
(down 25bps y-o-y), while one-year ARMs declined 4 bps to 5.12% (down 46bps
y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed
jumbo rates this week down 6 bps to 7.12% (up 20bps y-o-y).
Bank Credit rose $22.9bn to $9.576TN (week of 9/24), with a 3-week gain of
$183.7bn. Bank Credit has expanded $363bn y-t-d, or 5.3% annualized. Bank
Credit posted a 52-week rise of $651bn, or 7.3%. For the week, Securities
Credit slipped $1.8bn. Loans & Leases jumped $24.8bn to $7.049 TN (52-wk
gain of $474bn, or 7.2%). C&I loans jumped $23.8bn, with y-t-d growth of
10.3%. Real Estate loans gained $7.1bn (up 1.4% y-t-d). Consumer loans rose
$5.2bn, and Securities loans jumped $23.9bn. Other loans declined
$35.3bn.
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